Cliff Wachtel's  Instablog

As acceptance of at least a partial Greek default grows among EU leaders, all PIIGS bond rates have been spiking over the past week to reflect increased risk premium now that the assumed EU put is gone.  As noted in last week’s post,  PRIOR WEEK’S LESSONS FOR NEXT WEEK: SEISMIC SHIFT IN EU DEBT RISK once you undermine the assumption that the EU will protect PIIGS bondholders from losses, then contagion  risk is on, and private investors will shun PIIGS bonds, or at minimum drive up PIIGS bond yields to reflect much greater risk now that assumed EU bailouts no longer there.

Thus no surprise that PIIG bond yields spiked. Moody’s downgrade of Ireland’s credit now means 3 PIIGS have junk bond ratings, Greece Portugal and Ireland. Meanwhile, the two others, the too big to bails, Italy and Spain, have bond yields at record levels.

Of most concern was that now, for the first time since the EU debt crisis began, Italian bond rates were soaring and bank stocks tanking.

Since the start of last week the week Italian government bonds have been in freefall. This sudden spike in yields comes at a particularly bad time, because Italy needs to refinance over €60 billion of bonds in the coming 6 weeks. With yields on its securities materially higher than the period prior, Italian Treasury will see its debt service costs soar in the near term, making fiscal adjustments much more difficult.

Why the sudden loss of confidence over the past weeks? Nothing about Italian fundamentals had really changed.

The best summary of the situation I’ve read was in an article from the German newspaper Die Zeit Understand The Banks And You Save The Euro (via seekingalpha.com, in its always-must read Global and Fx currents section). The following is a summary of the articles key points, with a few of my own observations added.

• While Italian government debt may well be high, unlike other countries, it’s not getting any higher. The banks are healthy, as are private household finances. So why are the markets panicking, and why now?

• While there may be some truth to EU politicians blaming speculators, Wall Street, or US conspiracies against the EU or EUR to preserve the dominance of the USD (although US policy in recent years has clearly been indifferent to the fate of the USD), in fact the real cause of the sudden spike in Italian and other PIIGS bond yields, and collapse in and confidence is the EU’s own recent policy change.

As I noted in last week’s weekly review and preview, Last Week’s Lessons for This Week: Seismic Shift in EU Debt Risk Part 1, once the EU changed its mind about protecting bondholders from losses and removed the implied EU guarantee of PIIGS debt, the risk for these instruments rose dramatically. So of course that was quickly reflected in PIIGS bond yields. That in turn makes a PIIGS default more likely, and once we get one, the rest will follow, as will many of the banks holding those bonds or those that insured them, as credit markets boycott PIIGS debt.

The idea is not new, it’s just something the EU’s voters don’t want to hear.

As ECB President Trichet has warned, attempts to impose losses on PIIGS bondholders that have been financing the EU’s debt will scare away these vital funding sources just when they’re most needed.

Continuing with the articles key points:

• In sum, ironically, through this decision to inflict losses on the PIIGS bondholders, the countries of Europe are scaring off exactly the financiers needed to save them.

• Tension in the EU began its most recent leg higher when Moody’s downgraded Portuguese debt, largely because, per a Moody’s note to clients:

“the increased likelihood that the participation of the private sector will be demanded” in the pay-out of new emergency loans. What worries the rating agency is what the German federal government, above all, is determined to push through: contributions by banks and insurance companies to finance the rescue package. Voluntarily, but if need be under the threat of coercion. That’s what Merkel and Schäuble have promised the Bundestag – and the unruly members of the coalition government.

And that’s the problem. Banks and insurance companies ultimately are paid for investing their clients’ money profitably. If losses loom, they must draw back. It played out that way in Greece and Ireland, and it’s playing out that way now in Portugal and Italy.

Led by the Germans, the Europeans have manoeuvred themselves into a strategic corner. Either they do without the short-term involvement of the big money houses and alienate their parliaments, or they stand up to Wall Street and risk massive capital flight. Either way, with each passing day the governments spend dithering, the uncertainty increases. Hence the crisis…. John Taylor, a foreign exchange speculator, compares the common currency to a chicken that’s had its head chopped off and is still running around for a while, before falling over dead.Divided, hesitant, dithering: that’s how the investors see Europe, and that’s why they prefer to invest their money elsewhere…..So goes Europe into the end-game of the euro, deeply divided… it is also clear that the Europeans can never come up with all the capital it needs to finance the indebted states. And that is why Europe needs precisely those financiers it is driving off.

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See the rest of the article for more details.

As we’ve noted before, this is a global crisis potentially much greater than that which followed the Lehman collapse.

Lehman Bros was a large bank. Spain and Italy, together represent about 35% of the EU’s GDP, are far too big to bailout if they’re unable to access credit markets at affordable rates. As in 2008, once again, banks will be so suspicious of one another’s solvency that interbank liquidity will seize up and detonate another collapse of the unregulated derivatives market, especially Credit Default Swaps (insurance on bond defaults) as insurers are suddenly overwhelmed with unanticipated claims they can’t pay (from this black swan event that their risk models didn’t anticipate), and voila, lots of insolvent banks, barring another round of bailouts and money printing to fund them. Virtually all major US banks heavily exposed through these, though not necessarily on EU debt.

Hello Global Double Dip, or Depression?

If the EU debt crisis metastasizes into a wave of defaulting nations and banks, well, a few likely consequences include:

• Eastern Europe, heavily dependent on the Western European banks for credit, gets sucked down
• China losses its biggest export market, goodbye China miracle
• Major banks worldwide, certainly in the US, are once again destabilized, so the troubled US economy takes another hit

Until credit markets gain clarity about the extent of losses they will bear, contagion fear and risk of sovereign and banking defaults continues.

For the longer term (positions to be held in months or years) shorting the EUR is an obvious choice, either directly by selling it vs. safer currencies, like selling the EURUSD, EURJPY, EURCHF, etc, or via Euro short ETFs like the EUO, or via weekly or puts on monthly EURUSD binary options. We like the monthly expirations because they allow more time for the longer term trend to assert itself.

For the coming week, however, taking positions on either the EUR or USD is treacherous

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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?